ZTE shares post biggest fall in three-and-a-half years on profit warning, U.S. probe

HONG KONG Mon Jul 16, 2012 5:00am EDT

Employees of ZTE chat on the roof of its headquarters in Shenzhen, Guangdong province, April 17, 2012. REUTERS/Tyrone Siu

Employees of ZTE chat on the roof of its headquarters in Shenzhen, Guangdong province, April 17, 2012.

Credit: Reuters/Tyrone Siu

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HONG KONG (Reuters) - Shares of ZTE Corp (0763.HK), the world's fifth-biggest telecommunications equipment maker, logged the steepest fall in more than three years in Hong Kong as a profit warning and a probe by the U.S. government cast a gloom over the company's near-term fortunes.

ZTE's stock slumped 16.3 percent to close at HK$10.46 on Monday in the largest decline since October 27, 2008. Trading volume was nearly seven times that of its 30-day average.

Chinese telecoms equipment manufacturers including Huawei Technologies Co Ltd HWT.UL have been hit by sluggish global spending on networking gear, with ZTE saying last week that first-half profit could slide as much as 80 percent.

The earnings warning, which triggered a slew of brokerage downgrades, came as a report emerged that the FBI has opened a criminal investigation into ZTE over the sale of banned U.S. computer equipment to Iran and its alleged attempts to cover it up and thwart a Department of Commerce probe.

"The FBI probe would adversely affect ZTE's ability in bidding for overseas projects, and it's a major negative," said Lou Zhen, a fund manager at Shanghai Anode Industrial Investment Co, which doesn't own ZTE shares. "Investors have reason to be concerned about the company's growth prospects and there's still room for the stock to fall."

ZTE's China-based spokesman David Dai Shu denied that the company's subsidiary in the United States is involved in products for non-U.S. markets like Iran, but declined to comment when asked about allegations of a cover-up.

ZTE's majority shareholder Zhongxingxin Telecom Equipment Ltd, a low-profile Chinese company with close links to the state, could not be immediately reached for comment.

The Chinese company could face steep fines and restrictions on its U.S. operations if it is found to have illegally sold U.S. computer products to Iran.

An investigation by the European Union Commission on whether Huawei and ZTE have accepted illegal subsidies from the Chinese government has also pressured ZTE's shares in the past month.

"The biggest risk in investing the stock is that it's non-transparent. It's related to the nature of the business and coupled with the fact that the management is not really that willing to talk to the investors," said Jenny Tian, a managing partner at Hong Kong-based hedge fund Springs Capital.

Zhongxingxin Telecom Equipment, based in the southern city of Shenzhen, holds a majority stake of 37.65 percent in ZTE 000063.SZ. The telecoms equipment maker also counts China Life Insurance Co (601628.SS) and BlackRock Asset Management among its shareholders.

STIFF COMPETITION

ZTE is also hit by stiff competition in the mobile phone business in China, the world's biggest market by subscribers, and delays in Chinese telecom equipment tenders.

The Shenzhen-based company, which is also the world's fourth-biggest handsets vendor, has seen its gross profit margins fall to 29.7 percent, lower than Alcatel's (ALUA.PA) 39.9 percent and Ericsson's (ERICb.ST) 38 percent, according to Thomson Reuters StarMine data.

"We were wrong to assume operating margins should improve after ZTE builds up scale. The fierce competition pressured the ASP (average selling price) and margins. This is likely to persist into 2013," CLSA said in a report.

Some analysts expect ZTE's gross profit margin to be around 28 percent for the whole of this year.

"We were late downgrading the stock, as we were too optimistic on the speed of margin expansion of the company," JPMorgan said in a report.

JPMorgan, one of the most aggressive downgraders among brokerages including CLSA, Credit Suisse and Jefferies, cut its rating on ZTE to underweight from overweight and more than halved the target price of the stock to HK$10.

ZTE has a forward price-earnings ratio of 10 times, higher than Ericsson's (ERICb.ST) 9.8 times and Alcatel-Lucent's (ALUA.PA) 7.9 times, according to Thomson Reuters StarMine. This implies ZTE's stock is overpriced compared with its peers.

"We're quite negative on the stock, mainly because they are unable to lift their gross margins as they've been focusing on gaining market share at low prices. Some of their contracts are money-losing after factoring the costs of their operations in certain markets," said a Hong Kong-based analyst at a fund management company that invests in ZTE shares.

A fall in the euro and many emerging currencies due to the European debt crisis has also caused ZTE to take a foreign exchange loss in the first half, versus a gain a year earlier, the company said last week.

Overseas markets such as Africa and Europe accounted for around half of ZTE's revenue last year.

(Reporting by Lee Chyen Yee, with additional reporting by Samuel Shen, Nishant Kumar and Vikram Subhedar; Editing by Ryan Woo)

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